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Choice Hotels: Leisure Travelers Back on the Road

Michelle Chang, CFA

Michelle Chang: Hi. This is Michelle Chang. I'm a stock analyst and we are here at the Morningstar Stocks Conference and joining me today is Steve Joyce, CEO of Choice Hotels. Thanks for joining me today.

Steve Joyce: Good morning, Michelle.

Chang: So, we like Choice Hotels because they have a great asset-light business model, produces great margins and returns on invested capital, and we think that deserves a narrow economic moat. Can you tell us a bit more about the business and what else gives Choice a competitive advantage over its rivals?

Joyce: Yeah, we think our pure franchise play position, because that's all we do is franchise, gives us the opportunity, and now that we have developed really a massive scale – we're at 6,000 properties worldwide. That allows us to generate a lot of value for our franchisees, but it also – we can do it without investing a lot of capital and so the margins that we run both on our business of the franchising it and our return on investment is really quite impressive.

That allows us to provide a lot of value to our franchisees, to grow the business without putting a lot of capital into it and then seek out new opportunities where our scale can help us. So, one of the things we've got a big push on now is internationally, and the nice thing about our business is, we do both new build and conversions.

In this cycle for the next couple of years, we believe all the action is going to be in conversions. We think that puts us in a really good place to capture more than our fair share, continue to grow our share of not only the U.S. market, but also hopefully some internationally as well. And to look to continue to grow our base of franchisees and properties.

Chang: Sounds great. Also, as you mentioned, the sort of new development market is slowing down, financing is tough for franchisees to find. Dig into a little bit more detail about the commercial markets. Do you see that both domestically and internationally?

Joyce: Yeah, where we're focused and where the markets that look the same are really, if you look at the U.K. and Europe and you look at the U.S., very similar characteristics of pretty tough environment financially, pretty tough financing environment. Construction financing really not available, but lots of independent or other branded properties that are looking to upscale their property to make an investment, hopefully, make their hotel more revenue and profit intensive.

So, we see real opportunity over the next couple of years for our brands, particularly for Quality, Econo Lodge and Clarion, with our single advantage that we've got, which is our above property management system. We've got the only really truly Internet-based systems out there that are massively distributed. And so that's going to give us a real advantage because our cost to conversion for an individual franchise is lower as a result of the fact that they don't need to buy equipment and cabling and all those other stuff.

Basically if they've access to the Internet, they've got access to our systems. That's going to really help us in that conversion market and we are also well known for our brands. People know that when they convert to our brands that we are going to generate real business for them, that's not true for the rest of the brands.

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Chang: What about growing through brand acquisitions. Are there any areas that you see opportunity on that front?

Joyce: Yeah, and we've sort of been pretty public about the fact that we'd love to buy a full-service brand. We actually were hoping that the turmoil in '09 would lead us to an acquisition that would make some sense. We had a couple of conversations, none of them turned into a deal. We'll continue to have lots of dialogue. It is a stated goal of ours, but we are a patient buyer.

We are going to fund the right deal at the right price. Depending on where business goes next year, may create some more opportunities. We don't have anything pending immediately, but it's one of our goals to move more aggressively into that upscale space, and the reason being is we are very strong moderate tier and below.

Cambria is going to be an excellent opportunity for us to go upscale, but it will be slowed by that financing environment and picking up our branded full service were really bring in business customers because we're so leisure oriented with business customers, really round out the portfolio and make for a very interesting proposition for us.

Chang: With the past three quarters, we've seen improving results in Choice's, both in RevPar and profitability. Looking ahead, I think the economic picture is pretty much at a steady state where unemployment is still projected to be fairly high at almost 10%, how dependent on the general economic conditions recovering is sort of the continued recovery that we see in Choice Hotels' results?

Joyce: Well, that's the interesting thing because normally I would say fairly dependent. I would say, we swing up when we see a swing up in employment or when we see a swing up in GDP growth, when consumer confidence rises. But what we've seen over the last summer which is really a pleasant surprise, for a change, is in spite of a lowering consumer confidence, no improvement in employment and a GDP that appears to be slowing into the back end of the year, we've actually taken off. We had an excellent third quarter.

We were up about 7.4% in our RevPar growth which is by far – we were negative in quarter one, relatively neutral quarter two, but really took off, had a great summer. That's carried into the fall, and then because of the no supply increase, I think most people in the business are sort of convinced that we're going to have a pretty good year, next year, almost regardless because demand is coming up, corporations are profitable, the 90% of the folks that have jobs are traveling and so we're seeing that in our numbers now. We think that will continue into next year, and then if we get any help with consumer confidence or employment or GDP growth, that will make the difference between a good year and a really good year.

So, we're pretty optimistic about Choice's position because we're a strong conversion brand and that's where all the action is going to be. Then the other thing that we think is different about this time around is there is really a value orientation on the consumers' side and so the consumer is thinking about their hotel stay, what they are trying to do, the fact that we give a free breakfast, free Internet, free parking and make a hell of a waffle, which is always important, and the fact that people can say, hey I can do that and I can spend money on taking my kids to a park or I can spend money on taking my client to dinner instead of dumping in into my hotel room. We think this bodes well for us for the next several years.

Chang: Do you think that a return in rate will continue. I know rate was about flat in your most recent quarter?

Joyce: Yeah, we're up slightly, which is a big improvement over where we've been. I think what will happen first is what happens normally in this cycle is, we'll see a nice swing up in demand and then based up on that swing up in demand by market we'll have the opportunity to begin pricing as well. Pricing will improve because what we'll do initially is we'll begin to cut off some discounted rates. So, rates that were discounted that we no longer need because we're being able to sell in regular thing. They call that rate shift.

So the segmentation shift will help us raise our rates some, and then when we start getting some really strong occupancy performance, for us we're inverted, so when the weekends are full, that allows us to begin pricing the hotels up. That's probably 18 months to 2 years off for a significant price increase, but I think you will see steady price increases going through next year.

Chang: Great. Thank you, Steve.

Joyce: My pleasure. Nice to see you.